Retirement Basics: Common Sources of Retirement Income
Social Security Benefits
Though the future of social security is uncertain to say the least, right now the deal is that you pay into the system for as long as you work (6.2% up to the "wage base"--$102,00 in 2008), whether you're an employee or self-employed. In the case of the employed, the employer must also pay the same 6.2% on the worker's wages. In addition, both the employee and the employer must pay another 1.45% each on the total yearly income of the worker. The self-employed do not pay Social Security tax as such, but under a separate law are required to pay 15.3% of their total income; they basically pay both the employee and the employer shares of the Social Security tax, though they can deduct half (the employer's share) when they file their federal income taxes.
The calculation process for how much Social Security benefits a person will receive is ridiculously complex, so I won't get into it here, suffice it to say that it's based on the average of the worker's covered earnings (the largest amount covered in 2008 was $102,000) for the 35 years in which the worker earned the most.
Workers can begin receiving benefits at age 62, but they will be "reduced benefits." Workers are not eligible to receive the full benefits until the normal retirement age, which is currently defined as 67 years old for anyone born after 1960. For ever year after normal retirement age that a worker delays receiving benefits, the benefit amount will increase when they do begin accepting them.
Social Security also provides for the worker's spouse (though currently same-sex spouses are not covered) and children, and with a little maneuvering, it is even possible for the spouse and children to receive benefits even if the worker decides to continue working after his or her retirement age. A worker's widow or widower is similarly provided for, as is, in some cases, even a divorced spouse or divorced widow(er).
The problem is that even if (and it's a big IF) social security benefits are still around by the time we get to retirement age, it's doubtful they'll be enough to live comfortably on. Even now, the average individual's monthly social security check is only around $950, and it's taxable. Obviously, you're going to want to secure other sources of retirement income.
For more information about Social Security benefits visit their website.
Work Pension Plans/Employer-Sponsored Benefit Plans
There are two main types of employer-sponsored retirement plans: defined benefit plans and defined contribution plans.
A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service--for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
A Cash Balance Plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 percent of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee's individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions generally are invested on the employee's behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.
A Simplified Employee Pension Plan (SEP) is a relatively uncomplicated defined contribution plan geared towards the self-employed and owners of small businesses. A SEP allows individuals to make contributions (up to 25% of their annual earnings with a maximum of $49,000) on a tax-deferred basis to individual retirement accounts (IRAs). Fidelity has a good site with more detailed information regarding SEPs and even an SEP-IRA Contribution Calculator.
Savings Incentive Match Plan for Employees of Small Employers (SIMPLE)
Don't get confused, you're right--whoever thought up the acronym for this defined contribution plan cheated a bit. Nevertheless, that's what it is, even though it's easy to confuse with the Simplified Employee Pension Plan above. Whatever. There are two main options for this type of tax-deferred IRA: 1) the employer contributes 2% of the employee's pay each year and the employee is able to contribute up to $10,500 per year. 2) The employee contributes to the plan (with the same maximum contribution) by deferring a percentage of their salary, and the employer must match that contribution (up to 3% of the employee's salary).
A Profit Sharing Plan or Stock Bonus Plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution.
A 401(k) plan is a defined contribution plan where employees can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes, to the 401(k) account. Sometimes the employer may match these contributions. The money in the account is then invested in stocks, mutual funds, and/or other securities. There are special rules governing the operation of a 401(k) plan. For example, there is a dollar limit on the amount an employee may elect to defer each year. An employer must advise employees of any limits that may apply. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their own investments.
An Employee Stock Ownership Plan (ESOP) is a form of defined contribution plan in which the investments are primarily in employer stock.
A Money Purchase Pension Plan is a defined contribution plan that requires fixed annual contributions from the employer to the employee's individual account.
For non-retirement specific investment information, see our Investments Primer.